Iran’s Return to the Global Oil Market Is No Cause for Panic

The lifting of economic sanctions against Iran this past week is no reason for the oil markets to panic. While the addition of somewhere between 500,000 and 1 million barrels of Iranian crude per day to an already oversupplied market may seem like the end of the world to those bullish on oil prices, the reality is far less dramatic.

As Iranian crude comes back online, non-OPEC oil supplies, especially those in the U.S., where production prices still remain well above current selling prices, will begin to fall off a cliff. This, combined with a subsequent increase in demand, should eat away at the worldwide oil glut, causing prices to rise, not fall, throughout the year.

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One would think that the lifting of sanctions on Iran’s battered energy industry over the weekend came as a great surprise to the oil markets. Brent crude, the international crude benchmark, opened Friday, the day before the deal went into effect, trading at around $31 a barrel. By the close of trading on Tuesday (Monday was a market holiday in the U.S.), Brent crude had fallen 8%, closing at a new 12-year low of $28.55 a barrel. This sharp drop was blamed mostly on the lifting of the sanctions and the anticipated flood of Iranian supplies expected to hit the market.

If the markets had suffered such a sharp drop in the weeks just following announcement of the deal, that would make far more sense. Strangely, Brent crude prices hardly moved from the beginning of April, when the Iran nuclear deal framework was first announced, to the middle of July, when negotiations with Iran and the P5+1 coalition (United States, China, Russia, France, U.K., and Germany) concluded, holding at around $57 a barrel on both dates.

But in the months that followed, Brent crude prices responded, dropping 40% by the end of the year to around $37 a barrel. While this sharp drop in prices cannot be attributed solely to the prospects of Iran’s unrestricted return to the world oil market, it certainly contributed to it. That is why the recent 28% drop in Brent crude prices from the start of the year to around $28 a barrel seems a bit severe.

But there is real fear out there that Iran’s return to the global oil markets could have a profoundly negative impact on both the short and medium outlook on prices. Before the nuclear sanctions were instituted in 2012, Iran was OPEC's second largest supplier of crude, producing around 4 million barrels a day, of which it exported some 2.3 million barrels. That is more than double the 1 million barrels of crude per day Iran is currently exporting to its sanctioned customers in Asia.

While it won’t take as long for Iran to build its production up to its pre-sanctions levels as the bears believe, it’s not going to happen overnight, as the bulls believe, either. Bears like to point out the long lead time that was needed in Iraq and Libya to get their oil wells back up and pumping following years of being under the yolk of Western sanctions. But that’s a poor comparison, as Iran’s oil infrastructure was neither damaged nor destroyed, as was in the case in those countries.

Condensate is a semi-gaseous light oil, which, due to its high sulfur content, cannot be processed by most of the world’s refineries. The ones that do process this kind of oil usually have their supply totally covered, so there is no viable “spot market” for it. In April, one of Iran’s biggest customers of condensate stopped taking deliveries due to a fire at one of their facilities in China. So, out of the 9 million barrels of condensate Iran produces each month, 2 million had no home. This might help explain some of the buildup in floating storage, although it doesn’t account for all of it. In any case, it is safe to say that a large chunk of the buildup isn’t crude. So, the flotilla’s impact on the oil price may not be as pronounced as many in the market believe.

At the end of the day, it all comes down to supply and demand. As Iran ramps up production, it will be countered by a similar decrease in activity in places where oil is more expensive to produce. Hedges helped keep many shale oil producers in the United States afloat through 2014 and most of 2015. But those investment positions will begin to roll off this year, leaving many companies totally exposed to low oil prices. As a consequence, U.S. oil production is projected to fall by 400,000 barrels a day by the end of the year, according to Wood Mackenzie, an oil consultancy. The firm also predicts a decrease in production of around 200,000 barrels a day in the rest of the world, equating to a combined 600,000 barrel per day decline.

That essentially cancels out the 500,000 extra barrels that Iran says it will be producing by the end of the year, as well as most of the storage. Since demand is expected to increase by 1.3 million barrels a day next year, the current supply overhang could disappear fast. While we aren’t likely to see $100 oil by December, it is safe to say that oil prices won’t be ending the year in the $20s.